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U.S. Tactic on KPMG Questioned

A federal judge ruled yesterday that a tactic used by prosecutors to crack down on corporate misconduct violated the constitutional rights of employees, a decision that may change the way the government pursues white-collar cases.

The ruling, by Judge Lewis A. Kaplan of United States District Court in Manhattan, who is overseeing the trial of former employees of the accounting firm KPMG, is the first major criticism from the bench of tactics that federal prosecutors have adopted since a wave of corporate scandals erupted after the collapse of Enron.

The issue addressed by Judge Kaplan concerns the advancing of legal fees to employees caught up in criminal investigations. Companies have traditionally paid such costs, and some states' laws and a number of companies' bylaws require it. But an influential 2003 Justice Department document known as the Thompson memorandum has been interpreted by many lawyers to mean that companies under investigation can gain favor with prosecutors if they cut off legal fees.

Prosecutors have argued that the Thompson memorandum guidelines are simply factors that prosecutors must consider in evaluating a company's cooperation and are not ironclad requirements. Defense lawyers and corporate lawyers, however, contend that the memorandum is being used as a club to bludgeon companies into disclosing legal secrets, cutting off legal fees and showing other signs of cooperation to avoid being indicted.

An indictment is often a death knell for a company, as it was for KPMG's rival, Arthur Andersen, which went out of business in 2002. Last month, the securities class-action law firm of Milberg Weiss Bershad & Schulman was indicted on charges of making more than $11 million in secret payments to three individuals who served as plaintiffs. Since then, the law firm has struggled to keep lawyers and clients from defecting.

In a strongly worded opinion, Judge Kaplan agreed with the defendants' contention that KPMG, which was under criminal investigation, was improperly pressured to cut their legal fees.

KPMG refused to pay the defendants' legal expenses, he wrote "because the government held the proverbial gun to its head."

The government, he said, "has let its zeal get in the way of its judgment."

Henry E. Hockeimer Jr., a criminal defense lawyer, called Judge Kaplan's opinion "a well-reasoned attack" on the Thompson memorandum, adding that it would probably deal "a death blow" to at least the guideline on legal fees.

"If there is a real sense that courts are not happy with this tactic and are pushing back, ultimately the D.O.J. may re-evaluate this and other aspects of the Thompson memorandum," he said.

A Justice Department spokesman, Brian Roehrkasse, said yesterday that the department was "surprised and disappointed by Judge Kaplan's novel conclusion, never before reached by any other court, that these guidelines are constitutionally suspect."

"The department remains committed to the principles and guidance set out in the Thompson memorandum," he said.

Nonetheless, there are signs that the Justice Department is scrutinizing how the guidelines are used.

The ruling, which may be appealed, applies only to the KPMG case and is at the level of a district court.

But because the federal court in Manhattan is home to so many high-profile white-collar and corporate fraud cases, Judge Kaplan's ruling carries extra weight, lawyers said. Judge Kaplan has served on the court since 1994.

Stephen J. Bronis, a Miami lawyer who is the chairman of the white-collar crime section of the American Bar Association, said the ruling "has the potential of being a watershed case that should operate as a signal to the U.S. attorneys not to use the guidelines as a coercive vehicle."

The judge, however, declined to dismiss the indictment against 15 former employees of KPMG, including a former vice chairman and a former chief financial officer. They face charges that they conspired to defraud the government by making and selling questionable tax shelters to wealthy investors. The trial is scheduled to begin in September. Sixteen employees were indicted last year, shortly after KPMG reached a $456 million deferred-prosecution agreement with the Justice Department last August. One former employee has since entered a guilty plea.

Until KPMG came under investigation in early 2004, the firm, like most corporations, had a decades-long practice of advancing and paying legal fees to employees caught up in inquiries.

But with the Thompson memorandum's view that advancing or paying legal fees is akin to protecting culpable personnel, and thus a mark against a firm facing indictment, that practice changed.

In 2004, as KPMG negotiated with prosecutors to avert an indictment, the firm first capped the legal fees, at $400,000, then cut them off entirely.

A senior KPMG executive and former federal judge, Sven Erik Holmes, said in recently disclosed court papers that "it was critical that the firm be in full compliance with the Thompson guidelines" regarding its treatment of employees whom it suspected of wrongdoing.

KPMG is regarded as a textbook example of how firms can avoid indictment by cooperating with prosecutors, in part by firing employees suspected of wrongdoing — even before they are found guilty — and by cutting off legal fees.

Photo

Judge Lewis A. Kaplan of U.S. District Court in ManhattanCredit
John Marshall Mantel for The New York Times

In his ruling, the judge wrote that during negotiations with KPMG, the government violated the employees' Fifth Amendment right to a fundamentally fair trial and their Sixth Amendment right to a lawyer.

An employer's payment of legal fees is "very much part of American life," he wrote, and applies to "bus drivers sued for accidents, cops sued for allegedly wrongful arrests, nurses named in malpractice cases, news reporters sued in libel cases and corporate chieftains embroiled in securities litigation."

The right to legal fees is "as much a part of the bargain between employer and employee as salary or wages," he wrote.

The judge also dressed down Manhattan prosecutors for being "economical with the truth" about pressuring KPMG to cut off the fees.

Michael J. Garcia, the United States attorney in Manhattan, said in a statement that, "We believe that the prosecutors acted ethically and properly throughout this case."

Judge Kaplan's criticism of the Thompson memorandum comes a month after the Justice Department basked in its biggest corporate fraud victory yet — the convictions of Enron's former top executives, Jeffrey K. Skilling and Kenneth L. Lay.

The guidelines were written in 2003 by Larry D. Thompson, the deputy attorney general at the time, after a wave of corporate scandals, including WorldCom, Tyco and Adelphia Communications among others. One of the guidelines that has also prompted much debate among lawyers concerns attorney-client privilege — treating communications between a lawyer and company executives as confidential.

The Thompson guideline encourages companies to share such communications with investigators, a move defense lawyers also criticize.

Prosecutors say they do not demand outright that a company under investigation disclose its legal secrets or cut legal fees to employees suspected of wrongdoing. The lead prosecutor in the KPMG employees' case, Justin Weddle, vigorously denied making any such demands of the KPMG defendants in hearings earlier this year.

Still, criminal defense lawyers say that the Justice Department may be out of touch with how individual prosecutors in 94 federal districts nationwide interpret the guidelines.

"What happens is you have corporations which are looking at the Thompson memo and which are in many ways at the mercy of the Department of Justice," said Daniel E. Reidy of Jones Day.

A recent survey by the Association of Corporate Counsels, a legal lobby, contends that "a culture of waiver" has emerged, with the government now routinely expecting corporations and employees to disclose private legal communications.

The association is part of a coalition that is pushing the Justice Department to revise its guidelines. The coalition also includes the United States Chamber of Commerce, the Business Roundtable, the National Association of Manufacturers and the American Civil Liberties Union. The American Bar Association also supports changes to guidelines, but it is not part of the coalition because its internal rules prohibit it from joining lobbying groups.

In February, the coalition met with Attorney General Alberto R. Gonzales and gave him a letter proposing changes to the Thompson memorandum.

The Justice Department has already taken steps to insure that prosecutors are not being overly aggressive with the guidelines.

Last fall, Robert McCallum, then the acting assistant attorney general, wrote a memorandum to all United States attorneys that asked them to obtain approval from supervising prosecutors before requesting the privilege waivers.

White-collar defendants in high-profile criminal cases can incur legal fees that run into tens of millions of dollars.

In the KPMG case, Judge Kaplan noted that the volume of evidence and the limited budget of many of the defendants had hindered their ability to construct defenses.

David Spears, a lawyer for one of the defendants, Jeffrey Stein, a former KPMG vice chairman whose fees were cut off last May despite a special severance package, said yesterday that "we are gratified that the court has recognized the unconstitutional aspects of the Thompson memorandum."

Others hailed the decision. The embattled law firm Milberg Weiss said in a statement, "We hope that courts will continue to hold the Justice Department accountable for such overreaching use of the Thompson memorandum."

Judge Kaplan cannot order KPMG to pay the fees or the government to pay the fees out of KPMG's $456 million fine.

He gave lawyers for the KPMG defendants 14 days to file a civil lawsuit claiming the fees against the firm, which has indicated it may countersue for breach of fiduciary duty.

George Ledwith, a spokesman for KPMG, said yesterday that the firm "was reviewing the opinion."